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Roth vs. Traditional 401(k): Study Finds a Clear Winner

Having been retired seven years the idea of tax-free income is appealing especially when most of my Social Security and all of my pension is taxed. I wish now I had used my employers Roth 401k option.

However, there is a debate as to which strategy is better; pre-tax contributions now or after-tax contributions now, taxes paid later or sooner? When will you be in the higher tax bracket? Which option will give you the best spending power in retirement?

A new study says there is a clear winner; the Roth 401k or the Roth IRA. However, there is a caveat. The assumption is that the participant’s savings rate does not drop when choosing the Roth. So, if you are saving 10% on a pre-tax basis, to maximize your spending power in retirement, when you switch to a Roth you must stay at 10% thereby lowering your take home pay by your tax rate times the value of the 10% per-tax amount. Let’s say you are earning $1000 a week and saving $100 pre-tax which become taxable. If you are in the 15% effective tax bracket, your take home drops by $15.00.

In return, when you need your 401k in retirement every penny you take out is tax-free. This may allow you to take out less above the minimum required distribution or spend less of the RMD.

New research shows that employees who choose a Roth 401(k) from their company’s menu of retirement plans might end up with more purchasing power in retirement than if they pick a traditional 401(k).

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Read WSJ article closely. It says the 20% or so of eligible who choose Roth save the same percentage.

However, it does not say anything about the 80% or so who reject the Roth option.

Wouldn’t everyone expect that those who choose Roth think it a better option for them? And if so, wouldn’t everyone also expect that those who choose or retain pre-tax over Roth either find pre-tax the winner or at least a draw?

The column and specifically the headline were intentionally written to misrepresent actual results since Roth became available in 2006.

That’s my point. The article suggests people making informed decisions would select Roth over pre-tax. Why would they assume that it was informed judgement among those who selected Roth over pre-tax? It just isn’t so. It is much, much more likely that they were looking at a 10% of pay rule of thumb, or a 6% of pay election necessary to get the full employer financial match.

If my crystal ball was working correctly when I was in my 20’s and had I known that I was going to make 6-figures and retire with a possible 6 figure income, I would have had a Roth IRA up to what the company matched and then invested the rest into an Index Equality funds. The capital gains tax is somewhere between 15 to 23% depending on income (I never had to find out how high). I am currently in the 28% tax bracket while I am still working.

But since I couldn’t afford a new crystal ball and had children, I worked my way from saving 3% to 15% contributions in a traditional 401K over the years. Without the tax advantage in the early years, I would never have saved as much as I did. I am not complaining about having to pay taxes now. It is a good problem to have. The name of the game is compound savings over a long time and I think I won since I’ll get to retire early.

Since a Roth IRA was not even available to me until the mid-2000’s it doesn’t matter. By then a Roth IRA was available for my wife so we took advantage of that even though it is only 1/10th of our retirement savings but it will give us some flexibility in our withdraws.

I will happily complain about paying taxes now. I’ll get a retirement. I do not think that my son will get that chance since the max he can save in an IRA is $5k a year. That is not enough with the unknown of health care costs 30 years from now. At least he has the option of online brokerage which was not available to me until the 2000’s and he can invest outside of a IRA but his wife is expecting any day now and we all know where the money goes then.

I favor the Roth IRA for higher income folks in their 30’s, because we do not know what the tax rates will be in 30 to 40 years. Of course this all depends on your total taxable income in retirement. For many the regular IRA works because they are under the taxable income levels with the higher standard deduction, personal exemption, that by the way are going up if the Rs can get a tax bill passed. Also, many in retirement with proper withdrawals prior to RMD do not see any of their SS taxed. You do not want to trigger tax on SS benefits if at all possible.

That may be true. But a quick check on a SS tax calculator and a single person receiving $30,000 SS benefit and taking $15,000 out of an IRA would only pay $375 additional tax on his SS benefit. There are plenty of people living on a lot less than $40,000 per year in retirement.

It looks like from what the tax calculator does, it is taxable income, not total income, so there is a bit of a break. That is why a single person with $45,000 total income is only taxed an additional $375 on SS benefit of $30,000. It looks like to me a married couple would not pay additional tax on a $30,000 SS benefit until total income was above $47,000. At $55,000 total income the tax on SS benefit would be an additional $600.

I planned out my retirement many years in advance. I live in a less expensive part of the country while still having all the conveniences close to home. I paid off everything including my house, Since I have zero debt, I can comfortably live on a modest income from early social security and what I take out of my traditional IRA. Those IRA distributions would be taxable. But each year, I take out just enough to keep me under the IRS tax threshold. So not only do I not have to pay taxes, I don’t have to file a tax return. The irony is… I still take out a larger distribution than I need to live, so I add that to my regular savings. Even though I live modestly, I am hardly deprived. I still eat out and shop within reason. But the most valuable thing I have is my freedom, which is priceless.
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Many people living on the coasts or other high cost areas do not realize you can live well in retirement in many areas of the country on less than $20,000 per year. But you have to zero debt and have your cars paid off. I will be starting SS benefits, next year at 62. I live in Montana and my total monthly costs will be $1,500 and that includes $500 for food and all insurance, life, home, auto paid. My monthly income will be $2,850. I will be setting aside $300 per month for medical, but my medical expense this year has been less than $300, but I know this will not always be the case.

Your situation sounds similar to mine here in Texas. It’s amazing how well one can manage on a modest income with advanced planning that suits his own individual needs. One must plan based upon his own income, expenses and resources. One size does not fit all. Ironically, sometimes less is more. My being more savvy with my modest income often gives me an advantage over those who are careless with their high incomes.

Since my early retirement, I have been able to take out thousands of dollars each year from my traditional IRA tax free [and still stay under the tax threshold.] And I plan to continue doing that until the mandatory RMD.

Hi Smith, Glad to see there are still a few of us that know the value of a dollar and not to waste them.

I have never made more than $25,000 per year, many years a lot less. 20 Years service in the USAF 1975 to 1995 / raising 4 children with just part time work and a small military pension and you learn to manage money. I have not had a car payment since 1986, I always save up and buy used cars. Knowing how to do my own car repairs has saved me thousands over the years. Having a father who was a mechanic who taught me the value of doing repairs yourself. On cars, home electrical, plumbing, heating and air conditioning. I replaced my gas water heater, and fan motor on my furnace, saving me over $1,500, not bad for 3 hours work. Installed all new plumbing with correct shutoffs after pipes froze, while I was on vacation, savings over $2,000. I passed these skills on to my children, my 36 year old daughter fixed the door on her $2,000 refrigerator in 30 minutes, who knows what that would of cost her if she called a repairman. Most people I know today have a very limited skill set and it costs them plenty.